Chapter 3.Working Capital Management.ppt
- 2. Section 1 General Outlines of Working Capital Management 2
- 4. Working Capital Expressed as difference between current assets and current liabilities; Can be interpreted as money available to a company for day-to-day operations; It’s a common measure of a company's liquidity, efficiency, and overall health; Includes inventory accounts receivable, accounts payable, accruals and short-term debts; 4
- 5. Why It Matters? Positive working capital generally indicates that a company is able to pay off its short-term liabilities almost immediately; It means that company is able to maintain or grow sales, pay bills slowly, or collect receivables quickly; 5
- 6. Problems with Working Capital Formula The formula assumes that a company really would liquidate its current assets to pay current liabilities, which is not always realistic; a. the timing of receivables collection and payables due may not overlap all the times; b. some cash is always needed to meet payroll obligations and maintain operations; c. accounts receivable are not always readily available for collection, and some of them may be treated as bad debts; 6
- 7. Measuring of Working Capital Current Ratio Current Ratio= Current Assets/Current Liabilities Shows the ability of a business to pay for its current liabilities with its current assets; A working capital ratio of less than 1.0 is a strong indicator that there will be liquidity problems in the future, while a ratio in the vicinity of 2.0 is considered to represent good short-term liquidity;
- 8. Example Year 1 Year 2 Year 3 Current Assets $4,000,000 $8,200,000 $11,700,000 Current Liabilities $2,000,000 $4,825,000 $9,000,000 Current Ratio 2:1 1.7:1 1.3:1 Current ratio formula may be misleading by yielding higher results: a)when current assets are built on the account of inventories(they are hard to liquidate in short term basis especially when inventory turnover ratio is low); b) the same pitfalls are valid in the case of receivables; 8
- 9. Measuring of Working Capital Quick Ratio Indicates company’s ability to meet its short-term obligations with its most liquid assets. For this reason, the ratio exclude inventories as it takes some time to convert them into cash. The higher the quick ratio, the better the company's liquidity position. Quick Ratio= (Current Assets-Inventories)/Current Liabilities 9
- 10. Working Capital Management Focuses on two specific issues; a)administration of the firm’s current assets; b)the financing needed to support current assets; 10
- 11. Significance of Working Capital Management In a typical manufacturing firm, current assets exceed one- half of total assets; Excessive levels can result in a substandard Return on Investment (ROI); Low current asset level may lead shortages and difficulties in maintaining smooth operations; Working capital management affects the company’s risk, return, and share price; 11
- 12. Working Capital Management Policy A conservative approach aims to reduce the risk of system breakdown by holding high levels of gross working capital; An aggressive approach aims to reduce financing costs and increase profitability by cutting inventories, speeding up collections from customers and delaying payments to suppliers; 12
- 13. Working Capital Policy Illustrations Assumptions • 50,000 maximum units of production • Continuous production • Three different policies for current asset levels are possible Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSETLEVEL($) Current Assets Policy CPolicy C Policy APolicy A Policy BPolicy B 13
- 14. Impact on Liquidity Liquidity Analysis PolicyPolicy LiquidityLiquidity AA HighHigh BB AverageAverage CC LowLow Greater current asset levels generate more liquidity; all other factors held constant. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSETLEVEL($) Current Assets Policy CPolicy C Policy APolicy A Policy BPolicy B 14
- 15. Impact on Expected Profitability Return on InvestmentReturn on Investment = Net ProfitNet Profit Total AssetsTotal Assets Let Current AssetsCurrent Assets = (Cash + Rec. + Inv.) Return on InvestmentReturn on Investment = Net ProfitNet Profit CurrentCurrent + Fixed AssetsFixed Assets Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSETLEVEL($) Current Assets Policy CPolicy C Policy APolicy A Policy BPolicy B 15
- 16. Impact on Expected Profitability Profitability Analysis PolicyPolicy ProfitabilityProfitability AA LowLow BB AverageAverage CC HighHigh As current asset levels decline, total assets will decline and the ROI will rise. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSETLEVEL($) Current Assets Policy CPolicy C Policy APolicy A Policy BPolicy B 16
- 17. Impact on Risk • Decreasing cash reduces the firm’s ability to meet its financial obligations. MoreMore risk!risk! • Stricter credit policies reduce receivables and possibly lose sales and customers. More risk!More risk! • Lower inventory levels increase stockouts and lost sales. More risk!More risk! Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSETLEVEL($) Current Assets Policy CPolicy C Policy APolicy A Policy BPolicy B 17
- 18. Impact on Risk Risk Analysis PolicyPolicy RiskRisk AA LowLow BB AverageAverage CC HighHigh Risk increases as the level of current assets are reduced. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSETLEVEL($) Current Assets Policy CPolicy C Policy APolicy A Policy BPolicy B 18
- 19. Summary of the Optimal Amount of Current Assets SSUMMARYUMMARY OOFF OOPTIMALPTIMAL CCURRENTURRENT AASSETSSET AANALYSISNALYSIS PolicyPolicy LiquidityLiquidity ProfitabilityProfitability RiskRisk AA HighHigh LowLow LowLow BB AverageAverage AverageAverage AverageAverage CC LowLow HighHigh HighHigh 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!) 19
- 20. Section 2 Financing of Current Assets 20
- 21. Hedging (or Maturity Matching) Approach A method of financing where each asset would be offset with aA method of financing where each asset would be offset with a financing instrument of the same approximate maturity.financing instrument of the same approximate maturity. If long-term debt is used for financing short-term needs, the firmIf long-term debt is used for financing short-term needs, the firm will be paying interest for the use of funds during times when thosewill be paying interest for the use of funds during times when those funds are not neededfunds are not needed 21
- 22. Self-Liquidating Nature of Short-Term Loans Seasonal orders require the purchase of inventory beyond current levels; Increased inventory is used to meet the increased demand for the final product. Sales become receivables; Receivables are collected and become cash; The resulting cash funds can be used to pay off the seasonal short-term loan and cover associated long-term financing costs; 22
- 23. Risks vs. Costs Trade- Off Long-Term Financing BenefitsLong-Term Financing Benefits – Less worry in refinancing short-term obligations – Less uncertainty regarding future interest costs Long-Term Financing RisksLong-Term Financing Risks – Borrowing more than what is necessary – Borrowing at a higher overall cost (usually) ResultResult – Manager accepts less expected profits in exchange for taking less risk. 23
- 24. Risks vs. Costs Trade- Off Short-Term Financing BenefitsShort-Term Financing Benefits – Financing long-term needs with a lower interest cost than short-term debt – Borrowing only what is necessary Short-Term Financing RisksShort-Term Financing Risks – Refinancing short-term obligations in the future – Uncertain future interest costs ResultResult – Manager accepts greater expected profits in exchange for taking greater risk. 24
- 25. Section 3 Cash and Marketable Securities Management 25
- 26. Motives for Holding Cash Transactions MotiveTransactions Motive -to meet payments arising in the ordinary course of business; Speculative MotiveSpeculative Motive -to take advantage of temporary opportunities; Precautionary MotivePrecautionary Motive -to maintain a cushion or buffer to meet unexpected cash needs; 26
- 27. Cash Management System Collections Disbursements Marketable securities investment Control through information reporting = Funds Flow = Information Flow 27
- 28. Cash Management Involves the efficient collection,disbursement and temporary investment of cash; The general idea is the firm will benefit by speeding up cash receipts and slowing down cash payments; 28
- 29. Cash Flow Problems Making losses-if a business is continually making losses, it will eventually have cash flow problems; Growth-when a business is growing, it needs to acquire more non-current assets, and to support higher amounts of inventories and accounts receivable; Seasonal business-when a business has seasonal or cyclical sales, it may have cash flow difficulties at certain times; 29
- 30. Methods of Easing Cash Shortages Postponing capital expenditure; Accelerating cash inflows which would otherwise be expected in a later period; Reversing past investment decisions by selling assets previously acquired; Negotiating a reduction in cash outflows, 30
- 31. Possible Cash Positions Cash Position Actions Taken Short-term surplus Pay accounts payable early to obtain discount Attempt to increase sales by increasing accounts receivable and inventories Make short-term investments Short-term deficit Increase accounts payable Reduce accounts receivable Arrange an overdraft Long-term surplus Make long-term investments Expand Diversify Replace/update non-current assets Long-term deficit Raise long-term finance (such as via issue of share capital) Consider shutdown/disinvestment opportunities 31
- 32. Investment in Marketable Securities Marketable Securities are shown on theMarketable Securities are shown on the balance sheet as:balance sheet as: 1.1. Cash equivalents if maturities are lessCash equivalents if maturities are less than three (3) months at the time ofthan three (3) months at the time of acquisition.acquisition. 2.2. Short-term investments if remainingShort-term investments if remaining maturities are less than one (1) year.maturities are less than one (1) year. 32
- 33. The Marketable Securities Portfolio Ready CashReady Cash Segment (R$)Segment (R$) Optimal balance ofOptimal balance of marketable securitiesmarketable securities held to take care ofheld to take care of probable deficienciesprobable deficiencies in the firmin the firm’s cash’s cash account.account. R$ F$ C$ 33
- 34. Controllable CashControllable Cash Segment (C$)Segment (C$) Marketable securitiesMarketable securities held for meetingheld for meeting controllable (knowable)controllable (knowable) outflows, such asoutflows, such as taxes and dividends.taxes and dividends. The Marketable Securities Portfolio R$ F$ C$ 34
- 35. Free Cash SegmentFree Cash Segment (F$)(F$) ““Free” marketableFree” marketable securities (that is,securities (that is, available for as yetavailable for as yet unassigned purposes).unassigned purposes). The Marketable Securities Portfolio R$ F$ C$ 35
- 36. Variables in Marketable Securities Selection Marketability (or Liquidity)Marketability (or Liquidity) The ability to sell a significant volume of securities in a short period of time in the secondary market without significant price concession. SafetySafety Refers to the likelihood of getting back the same number of dollars you originally invested (principal). 36
- 37. Variables in Marketable Securities Selection MaturityMaturity Refers to the remaining life of the security. Interest Rate (or Yield) RiskInterest Rate (or Yield) Risk The variability in the market price of a security caused by changes in interest rates. 37
- 38. Common Money Market Instruments Treasury Bills (T-bills)Treasury Bills (T-bills):: Short-term, non- interest bearing obligations of the U.S. Treasury issued at a discount and redeemed at maturity for full face value. Minimum $1,000 amount and $1,000 increments thereafter. Money Market InstrumentsMoney Market Instruments All government securities and short-term corporate obligations. (Broadly defined) 38
- 39. Common Money Market Instruments BankersBankers’ Acceptances (BAs)’ Acceptances (BAs):: Short-term promissory trade notes for which a bank (by having “accepted” them) promises to pay the holder the face amount at maturity; Repurchase Agreements (RPs; repos)Repurchase Agreements (RPs; repos):: Agreements to buy securities (usually Treasury bills) and resell them at a higher price at a later date; 39
- 40. Common Money Market Instruments Commercial PaperCommercial Paper:: Short-term, unsecured promissory notes, generally issued by large corporations (unsecured IOUs). The largest dollar- volume instrument. Negotiable Certificate of DepositNegotiable Certificate of Deposit:: A large- denomination investment in a negotiable time deposit at a commercial bank or savings institution paying a fixed or variable rate of interest for a specified period of time. 40
- 41. Common Money Market Instruments . EurodollarsEurodollars:: A U.S. dollar-denominated deposit -- generally in a bank located outside the United States -- not subject to U.S. banking regulations 41
- 42. Selecting Securities for the Portfolio Segments Ready CashReady Cash Segment (R$)Segment (R$) Safety and ability toSafety and ability to convert to cash is mostconvert to cash is most important.important. SelectSelect U.S. TreasuriesU.S. Treasuries for this segment.for this segment. R$ F$ C$ 42
- 43. Controllable CashControllable Cash Segment (C$)Segment (C$) Marketability lessMarketability less important. Possiblyimportant. Possibly match time needs.match time needs. May selectMay select CDs,CDs, repos,repos, BAs,BAs, euroseuros forfor this segment.this segment. R$ F$ C$ Selecting Securities for the Portfolio Segments 43
- 44. Free Cash SegmentFree Cash Segment (F$)(F$) Base choice on yieldBase choice on yield subject to risk-returnsubject to risk-return trade-offs.trade-offs. Any money marketAny money market instrumentinstrument may bemay be selected for this segment.selected for this segment. R$ F$ C$ Selecting Securities for the Portfolio Segments 44
- 45. Thank You
Editor's Notes
- #5: Negative working capoitsal